Economic Logic, Too

About Me

I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Thursday, July 24, 2008

The US Congress has finally found the scapegoat for high oil prices. While most of the increase is due to the fall of the US dollar that will eventually rectify itself, it found speculators to be guilty and intends to rein them in. This is nonsense.

Speculators are regularly vilified because they manage to make money without being apparently productive. Yet, they provide some very important functions on the market: they help hedging against risks, and more importantly, they help prices being informative of true economic conditions. Through their arbitraging, they make sure that goods are properly priced. For example, if an under-supply of oil is expected, they make sure that the price of oil reflects this. This allows producers and consumers to adjust to conditions. If prices would not reflect markets conditions, rationing could appear.

Yet it seems Congress wants exactly that: prices that do not reflect economic conditions. The current proposal is to inhibit the ability of speculators to arbitrage by preventing them to resell (which is at the core of arbitraging) and to deal with foreign markets.

There is no question that whenever markets are manipulated, intervention is necessary. How do you define manipulations? Albert Kyle and S. Viswanathan define a two-pronged test: Price manipulation needs to simultaneously undermine both pricing accuracy and market liquidity. In other words, their is manipulation if prices do not provide signals about economic conditions while there is evidence that someone is preventing trades from happening. Prices could be poor signals in liquid markets, but their is nothing one can do and nobody is benefiting from it. Prices can be accurate in illiquid markets, and that is not a problem. But both happening at the same time is a sign of manipulation.

Are oil prices currently manipulated? Given the size of the market, this is unlikely. But it has happened before, for example when the Hunt brothers manipulated the silver bullion market in 1979-80. At that time, they severely curtailed the liquidity of the market by hoarding. That does not seem to be the case with oil today. Oil markets are very liquid, and prices do reflect a real scarcity in addition to risk.

Note that what Congress proposes would be considered price manipulation, as transactions are prohibited (which lowers market liquidity) and prices likely would not reflect economic conditions (which undermines pricing accuracy). In other words, the proposal would make things worse... But it is responding to the call of doing something, and this is what counts in politics, right?